Standard & Poor’s Ratings Services says that the drivers of recent bank earnings are unsustainable, litigation reserves may have to increase, and mergers are becoming an increasingly distant prospect.

S&P says that all Canadian banks enjoyed strong performance in their investment banking and wealth management businesses in the second quarter, supported by buoyant capital markets. “This trend, however, is unsustainable due to slowing equity issuance activity and softer equity markets that point toward lower capital markets-related revenues in the third quarter,” it warns.

S&P also expects the banks to report litigation reserves in the next few months, to deal with Enron-related liabilities; as ongoing civil litigation suits could translate into legal charges for some Canadian banks. TD Bank has already set up a $300 million (pretax) litigation reserve. “Other Canadian banks may have to follow suit,” S&P says. “An element of risk could be the magnitude of those potential charges, as it is difficult to assess and quantify them at this time.”

S&P says sentiments have grown more negative towards the possibility of domestic bank mergers ever being approved. “At the same time the banks are faced with evident challenges in growing their franchises as the domestic retail banking market is mature and saturated, and U.S. strategies are being revisited because of mixed results to date and somewhat disappointing returns on investments,” it says, noting that retail banking profits continue to be pressured by intense competition. In addition, there’s little evidence of corporate loan growth as most companies wanting to raise funds have been issuing debt.

“Overall, third quarter is not shaping up to be as favorable as the second quarter because intense competitiveness will keep pressure on net interest margins and signs of lower capital markets-related revenues are increasingly more evident,” S&P concludes.

“A minor increase in interest rates would provide some relief on pricing deposit liabilities and improve profitability although current economic conditions would not substantiate higher interest rates until at least fall 2004. Also, the notable improvement in the credit environment (large, foreign corporate loan book) since third quarter 2003, which has helped to lower provisioning requirements and boost overall profitability, offers little room to have any further benefit.”